Peloton: Opportunistic

Growing subs 120k this year despite cutting media spend $292m YTD, about to ramp marketing and launch a tiered app, and an exec being opportunistic at an all-time low stock price

Peloton reported its fiscal third quarter on May 4th. Here’s Barry’s shareholder letter, which is always a must-read. Here’s how he opened it:

This quarter showed continued progress on cost cutting, growth, and planting seeds for potential future growth. Underlying operating expenses excluding restructuring and impairment charges, supplier settlements, and the accrual of a one-time $75 million payment to DISH to settle a patent dispute fell to $407 million in the quarter. That is down from a peak of $697 million five quarters earlier. That is solid progress and there are more cuts to come.

Free Cash Flow

Barry’s number one priority has been getting to free cash flow breakeven. Free cash flow improved to -$55.3 million this quarter, a continuation of the steady improvement since Barry took over one year ago.

Excluding $18.5 million of supplier settlement payments—which are expected to fall to $3 million in the current quarter and then stop—and the $19.1 million civil penalty from prior management’s blunder handling the Tread+ recall with the CPSC—another non-recurring item—free cash flow would have improved even more to -$17.7 million. And even that included $21.9 million of cash payments for restructuring activities. So excluding all non-recurring items, Peloton was free cash flow positive this quarter.

Certainly, that is helped by the tailwind from working capital as the company sells down excess inventory over time. That was a $119 million source of cash during the quarter. And that source will diminish over the next 12 months as inventory comes more into balance. But that is a definitely a good thing as that will eliminate the excess storage costs that have been pressuring Connected Fitness gross margin. But it also means Peloton needs to continue growing gross profit and paring its operating expenses in order to become sustainably free cash flow positive without the benefit of working capital.

Of course, it is also helped by stock-based compensation, a non-cash expense but a real economic cost. But in this context, we are talking about free cash flow as it relates to liquidity, not free cash flow as it relates to valuation.

I should also point out the $75 million payment to DISH while accrued for this quarter will be paid in F4Q, which means free cash flow will take a temporary step back. But excluding that one-time item, they should be right there again despite it being the seasonally slowest quarter.

If anyone is still concerned about Peloton’s liquidity, I think that should be put to bed. The company will burn that $75 million DISH payment this quarter, but should be sustainably cash flow positive beyond that. EBIT is still negative but should continue improving due to subscription gross profit growth, Connected Fitness gross margins likely turning positive next year, and ongoing efficiency gains within opex, including closing most of the showrooms.

So I think we’ll still see negative EBIT in fiscal 2024 but adding back D&A net of capex, SBC, and the cash from inventory tailwind should create positive free cash flow for the year. There’s also the favorable working capital dynamics from the upcoming relaunch of the digital app, which will almost certainly offer an annual membership at a discount. If 200,000 existing digital app subscribers opt for the premium tier at an annual cost of $240, a discount from the rumored $24 per month price, that would generate $48 million of upfront cash flow. That’s the changing working capital dynamics Barry was referring to here:

I’m guessing we see EBIT turn positive during fiscal 2025. Peloton is also likely to sell what was once to become Peloton Output Park (“POP”) in Ohio sooner or later for perhaps $50 or $60 million. And Precor is likely to be sold sometime beyond that for maybe $300 million or more once they improve its financials.

In my opinion, long-term growth should be the bigger question mark than liquidity at this point.

Growth

On the growth side, Peloton reported 74k Connected Fitness paid net adds, again beating the guidance range of 47k-57k. That brought the Connected Fitness subscriber base to 3.11 million, up 4.9% year-over-year. It’s become clear Barry and Liz routinely guide on the conservative side. I continue to feel like most investors would be surprised to hear that Peloton has grown its subscriber base every single quarter even in the aftermath of the pandemic. Most would not guess that by looking at the stock chart or reading headlines.

However, management’s guidance for F4Q reflects its first ever decline for Connected Fitness subscribers, a 1% quarter-over-quarter decline to 3.08-3.09 million. I actually expected this guidance to be worse because a) it’s the seasonally weakest quarter of the year, b) Peloton only had 4k paid net adds in the year-ago quarter, and c) Barry guides conservatively. So the fact that guidance is only calling for a 1% decline makes me think we’re more likely to see a flattish or positive number.

Certainly, FaaS (the rental program) and PCR (Peloton Certified Refurbished) are helping growth. The two represented 24% of hardware sales last quarter and 62% of FaaS customers are incremental. Amazon is helping as well and Peloton will participate in its first ever Prime Day, likely in July, which could potentially drive some unseasonal strength in F1Q (Sept).

Management is also launching a media campaign later in May yet is not baking in any upside from this media campaign into guidance. Here’s Liz on the call:

I could be wrong, but it would seem unusual to increase media spending quarter-over-quarter for a brand relaunch campaign and not see any uplift in unit sales. We’ll see.

Growth Seeds

I think it’s clear one of Barry’s main goals is to…